For any tax professional who has ever had to review a client’s expenses for repair, acquisition, or production of tangible property, the question of whether to capitalize or expense is one that continues to stump even the most experienced CPAs due to the subjectivity involved and heavy reliance on facts and circumstances. Thousands of dollars of expenses may need to be capitalized in one situation, while the same amount may be deducted in another. This article addresses this issue along with some key points CPAs and taxpayers should consider. It briefly explains the benefits of expensing, limitations on capitalizing, and the application of two useful safe harbors: the de minimis safe harbor and the safe harbor for routine maintenance.
The benefit of expensing an item versus capitalizing it is readily apparent, but there are other factors to consider. If the amounts are below the de minimis threshold, the taxpayer will need to have documentation only to substantiate the amount paid. The taxpayer’s adviser and preparer will not need to spend time analyzing the support for, or nature of, the expenses, and there will never be an issue of recapture. With bonus depreciation phasing out and scheduled to be eliminated by the end of 2026, the impact of capitalizing an expense becomes greater. Even with bonus depreciation, taxpayers run the risk of dealing with depreciation recapture (where they must report previously taken depreciation as ordinary income) if an asset is disposed of before the end of its useful life.
The Sec. 179 deduction is also available in many instances but has its own complexities and limitations: which assets qualify; the maximum threshold to deduct; and most important, the inability of the Sec. 179 deduction to reduce the bottom-line income to a loss position. Granted, an excess Sec. 179 deduction carries over to future years, but it is not an immediate deduction in the year the expense is incurred. Also, another pitfall of the Sec. 179 deduction that many CPAs may not be aware of is that trusts and estates cannot claim it. Therefore, a client with a passthrough entity with a trust or estate as a partner should be aware that any Sec. 179 deduction allocated to such a partner will be a nondeductible expense for that partner.
The de minimis safe-harbor election
Regs. Sec. 1.162-4 provides that a taxpayer may deduct amounts paid to acquire or produce tangible property if the amounts paid are not otherwise required to be capitalized. One of the easiest ways to answer the often vexing question of whether to capitalize an expense is the de minimis safe-harbor election under Regs. Sec. 1.263(a)-1(f ). This election allows taxpayers to expense an item immediately, with no need to substantiate why it is not being capitalized.
It is important to note that the dollar threshold is applied per invoice (or per item as substantiated by the invoice). Therefore, even though taxpayers are not required to keep detailed documentation for items expensed under this election, taxpayers who purchase multiple items on one invoice should retain a copy of the itemized invoice. The election applies to the acquisition or production of a unit of tangible property, 1 materials or supplies, 2 and additional categories discussed in this article.
If the de minimis safe harbor is elected under Regs. Sec. 1.263(a)-1(f ), it must be applied to all materials and supplies that meet the requirements of de minimis, except for those the taxpayer elects to capitalize and depreciate or uses the optional method of accounting for rotable and temporary spare parts, under Regs. Secs. 1.162-3(d) and (e), respectively. This election does not apply to amounts paid for land; property that is intended to be included as inventory; or any rotable, temporary, or standby emergency spare parts that the taxpayer has elected to capitalize under Regs. Sec. 1.162-3(d).
The de minimis election is made annually by attaching a statement to the taxpayer’s timely filed original federal tax return (including extensions) for the tax year in which the amounts were paid. Most, if not all, tax software programs can produce this election statement. The taxpayer is also required to have an accounting procedure (in written form if the taxpayer has an applicable financial statement (AFS)) indicating that it will expense any item below the threshold and treat the amount paid as an expense on its financial statements and books.
See the sidebar on page 48, “Sample De Minimis Expensing Policy,” for an example of a written accounting policy for purposes of qualifying for the de minimis election.
De minimis threshold
There are two de minimis threshold amounts depending on whether the taxpayer has an AFS. An AFS includes any of the following: (1) a financial statement required to be filed with the SEC; (2) a certified audited financial statement that is accompanied by the report of an independent CPA; or (3) a financial statement (other than a tax return) that is required to be submitted to a federal or state government/agency (not including the SEC or IRS). 3 If the taxpayer has an AFS, the de minimis threshold is $5,000. If the taxpayer does not have an AFS, the threshold is $2,500. 4 Regs. Sec. 1.263(a)-1(f)(7) also provides a number of helpful examples addressing different scenarios. Example 3 is a good illustration of the threshold being used for individual items in an invoice where the de minimis safe harbor applies and a taxpayer has an AFS. Following is a summary of that example:
Example: Company C has a written accounting policy at the beginning of year 1, which C follows, to expense amounts paid for property costing $5,000 or less. In year 1, C pays $6,250,000 to purchase 1,250 computers at $5,000 each. C receives an invoice from its supplier indicating the total amount due ($6,250,000) and the price per item ($5,000). Assume that each computer is a unit of property under Regs. Sec. 1.263(a)-3(e). The amounts paid for the computers meet the requirements for the de minimis safe harbor; C must expense the purchases pursuant to C’s accounting policy; and C may make a de minimis safe-harbor election for year 1 and deduct the entire amount in year 1 for tax purposes.
Safe harbor for routine maintenance
Another safe harbor that can help taxpayers avoid the uncertainty of expensing versus capitalizing an item is the safe harbor for routine maintenance under Regs. Sec. 1.263(a)-3(i). This is more complex and has more criteria for eligibility compared to the de minimis election, but the scope of eligible maintenance costs that can be expensed is significantly broader. The term “routine maintenance” refers to costs incurred on a unit of tangible property or a building that are deemed not to improve that unit of property or building.
In order to apply this safe harbor, assuming it deviates from how the taxpayer has been accounting for such costs, the taxpayer will need to file a request for an accounting method change via Form 3115, Application for Change in Accounting Method, with designated change number 184. This is an automatic method change, so completing Form 3115 is relatively straightforward. Also, this is a one-time election that will apply to all subsequent years unless the taxpayer later decides to request another method change, unlike the de minimis election, which is an annual election and binding only for the tax year made.
Under the safe harbor for routine maintenance, the amounts incurred can be expensed as long as the purpose for incurring the expense is related to an ongoing activity in order to keep the unit of property or building structure or building system at or close to its original or efficient operating condition. The expense cannot improve the unit of property or building structure or system. Keep in mind that part of this requirement is that the wear and tear of the unit of property or building structure or system results from the taxpayer’s using it for its intended purpose. Expenses incurred related to scheduled maintenance shortly after the unit of property or building structure or system is purchased and/or placed into service would thus not qualify.
‘Routine’ aspect of expense
What does it mean for an activity to be “routine” in nature? This can be open to interpretation. Regs. Sec. 1.263(a)- 3(i)(1)(ii) provides an explanation as to what is routine in nature as well as some examples, which are not allinclusive. Routine maintenance may be performed at any time during the class life of the unit of property or building structure or system (discussed below). However, the activities are routine only if, at the time the taxpayer places the unit of property or building structure or system into service, the taxpayer reasonably expects to perform the routine activity more than once during its class life.
There is no clear answer as to what a routine expense is, but the regulations provide some examples and explanations regarding the requirement: The inspection, cleaning, or testing of the unit of property or building structure or system and/or the replacement of damaged or worn parts of the unit of property or building structure or system with comparable and commercially available replacement parts are all types of expenses that do not ultimately improve the unit of property or building structure or building system and therefore qualify as routine maintenance eligible to be expensed. Besides the examples provided in the regulations, other costs can be expensed, depending on a client’s specific circumstances.
A taxpayer’s expectation of performing the routine maintenance will not be deemed unreasonable simply because the taxpayer did not perform the maintenance more than once during the class life of the unit of property or building structure or system. The expectation would still be considered reasonable, provided the taxpayer can substantiate that, when the property or building structure or system was placed in service, it was reasonable to expect to perform maintenance more than once during its class life.
Sec. 168(e) provides a table that indicates the class life for each category of property when determining the depreciable life for tax purposes. Secs. 168(g)(2) and 168(g)(3)(B) go further into detail about the class life to be used when determining the “routine activity performed more than once during its class life” criteria. Sec. 168 also details other specific class lives for qualified improvement property, qualified technological equipment, automobiles, and certain real property that should be reviewed when applying this election.
Regs. Secs. 1.263(a)-3(i)(1)(i) and (ii) also identify key factors in determining whether the maintenance is routine and reasonable. According to these regulation sections, the taxpayer should consider the recurring nature of the activity, industry practice, the manufacturer’s recommendations, and the taxpayer’s experience and history with similar or identical property.
Examples of routine maintenance
Regs. Sec. 1.263(a)-3(i)(6) provides a number of examples that clarify the application of the safe harbor for routine maintenance. Example 1 provides a great illustration of how certain costs required by the manufacturer or a governing agency can be expensed as long as the item is a recurring one, does not improve the unit of property, and is within the class life of that unit of property.
Regs. Sec. 1.263(a)-3(k)(6) addresses the replacement of a major component or a substantial structural part of a unit of property. This type of expense can qualify for the routine maintenance safe harbor as long as the unit of property has not deteriorated to an unusable condition and the replacement is part of routine maintenance and recurs more than once during its class life. However, if the unit of property is being restored and thus improved, the taxpayer must capitalize the replacement’s cost.
A major component is a part or combination of parts that perform a discrete and critical function in the operation of the unit of property. 5 A substantial structural part is defined as a part, or combination of parts, that comprises a large portion of the physical structure of the unit of property, a definition that is open to interpretation. 6 Examples 25, 26, and 27 under subparagraph (7) in this regulation provide valuable illustrations of how these rules operate with respect to replacing windows on a building. This may be helpful to taxpayers who own residential or commercial buildings, and the concept can be applied to other aspects of the building structure or its systems.
These three examples involving the replacement of windows give useful insight into what the IRS views as a major component and substantial structural part. It is clear that windows are considered a major component of a building and can be a substantial structural part of the building. But what is important to note about these examples is whether a “significant portion” of the major component or substantial structural part has been replaced.
Example 25 illustrates when there is not a replacement of a major component or a substantial structural part. In it, a building has 300 windows that comprise only 25% of the surface of the building, and 100 out of the 300 windows were replaced. The example states that 25% of the building structure is not a substantial structural part of the building structure. Further, while the windows perform a discrete and critical function in the operation of the building structure and are a major component of the building structure, 33% of the windows does not comprise a significant portion of this major component. The cost of the window replacements therefore can be expensed.
In contrast, Example 26 shows that 200 out of 300 windows (approximately 67%) is considered a significant portion of the major component, and therefore the cost of replacing 200 of the windows must be capitalized.
Example 27 illustrates a unique scenario where the windows would need to be capitalized. According to the example, the 300 exterior windows, which represent 90 percent of the total surface area of the building, perform a discrete and critical function in the operation of the building structure and are, therefore, a major component of the building structure. However, the 100 windows replaced do not comprise a significant portion of this major component of the building. The example states that they do, however, comprise a substantial structural part of the building structure. Even though only 100 out of the 300 windows were replaced (approximately 33%), the windows replaced comprise a significant portion of the of the building structure. Thus the amount paid to replace them must be treated as a restoration that must be capitalized.
None of these percentages in the examples are part of the actual regulations. However, these examples show that there is room for interpretation as to what constitutes a significant portion of a unit of property while also providing some guidelines.
Two indispensable safe harbors
In summary, the de minimis safe-harbor election can simplify the decision-making process and provides more certainty for immediately expensing certain items, subject to dollar limitations. This method can save both time and administrative burden. However, it is crucial to remember that this election does not apply to land, inventory, or certain specialized spare parts. 7
On the other hand, the safe harbor for routine maintenance provides a broader ability to expense costs incurred to maintain property, so long as the property’s value is not enhanced. It may require filing Form 3115 for a method change, but this is relatively simple. The “routine” aspect of the maintenance is open to interpretation, so it is important to discuss this with your client to determine the best course of action.
The question of whether an expense must be capitalized or can be expensed is a critical issue that often perplexes CPAs and taxpayers alike. However, the de minimis and routine maintenance safe harbors are at the disposal of taxpayers and their advisers to help address this quandary. These two essential safe harbors offer distinct approaches in addressing this dilemma and will help taxpayers navigate the complex maze of the repair regulations. They provide tax advisers with the means to make informed decisions and better serve their clients. As the tax landscape evolves, this knowledge will prove indispensable, ensuring tax professionals are well prepared to handle repair expenses with confidence.
Sample de minimis expensing policy
This accounting policy establishes the minimum cost (capitalization amount) that shall be used to determine the capital assets to be recorded in our books and financial statements.
2. Capital asset definition and thresholds
A “capital asset” is a unit of property with a useful life exceeding one year and a per-unit acquisition cost exceeding $2,500/$5,000*. Capital assets will be capitalized and depreciated over their useful lives. We will expense the full acquisition cost of tangible personal property below these thresholds in the year purchased.
3. Capitalization method and procedure
All capital assets are recorded at historical cost as of the date acquired. Tangible assets costing below the aforementioned threshold amount are recorded as an expense for our annual financial statements (or books). In addition, assets with an economic useful life of 12 months or less must be expensed for both book and financial reporting purposes.
4. Documentation
Invoices substantiating the acquisition cost of each unit of property are to be retained for a minimum of seven (7) years.
*Tax capitalization threshold: The permissible ceiling for deducting otherwise capitalizable expenditures is $5,000 when our business has applicable financial statements. The threshold is limited to $2,500 in the absence of applicable financial statements.
1 Regs. Sec. 1.263(a)-2.
3 Regs. Sec. 1.263(a)-1(f)(4
4 Regs. Sec. 1.263(a)-1(f)(1)(ii)(D), as amended by Notice 2015-82.
7 Regs. Sec. 1.263(a)-1(f)(2).
Contributors
Nicholas Galletta, CPA, is a tax manager, and Celia Lau, CPA, is a partner, both at Navolio & Tallman LLP in Walnut Creek, Calif. For more information about this article, contact thetaxadviser@aicpa.org.
AICPA & CIMA RESOURCES
Cordonnier and Seo, “Blast From the Past: Tax Planning With the Repair Regs.,” 235-2 Journal of Accountancy 26 (February 2023)
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